For some clients, there comes a time when life insurance is no longer needed: maybe the children have grown up, or there are no heirs.
A common choice is to drop the coverage and take the cash surrender value, but is there a better option? If the client needs tax relief and wants to give back to the community, the answer could be in gifting the policy to a charity at fair market value (FMV).
When does a FMV donation make sense?
A term policy that is close to renewal or set to expire is a great option for donation if at renewal time, the policyholder or their family no longer wishes to maintain coverage.
Since, unlike permanent policies, term contracts generally do not have cash surrender value, absent a specific planning need, term insurance is generally considered worthless at the end of the term. This is a typical mistake and a major reason—aside from premium increases—that term policyholders are less apt to renew coverage. But, a term policy may have a FMV that far exceeds the cash surrender value.
A policy donation is an attractive way to realize additional value beyond the useful period of life insurance. Through a gift, a policy holder can receive a charitable tax credit that will both minimize personal taxes and support an important cause.
How does it work?
Typically, there are two ways to donate. The most common way to gift a policy is by simply assigning the charity as the beneficiary, and upon death, the estate would receive a tax credit based on the amount of the gift.
The second method is to change both the policy ownership and beneficiary to the charity. Clients wanting to go that route should consult the charity beforehand to be certain they accept a gift by this method. (Note that this article pertains to direct donations to the intended registered charities, and does not cover the use of third parties.)
Tips for donating policies
If your clients donate policies at fair market value, make sure they can use the full donation tax credit, since they can only deduct up to 75% of net income each year while alive and can only carry the credit forward for five years.
Clients can also donate paid-up policies or convert policies to paid-up before donating them.And if clients choose to use an intermediary charity for their donation, tread carefully. Read Advisor.ca’s investigation into the limits and pitfalls here. For the investigation, Adam Aptowitzer, an Ottawa-based charity lawyer with Drache Aptowitzer LLP, told Advisor.ca, “The end charity should be involved in the donation of the insurance policy to the intermediary so [the end charity] can confirm with the donor that the money will be going to whatever the donor wants, and that after the policy matures, the donation will occur on a timeline that both sides are happy with.”
In the second case, CRA deems that policy donations occur at FMV; the benefits to the donor are immediate. The donor receives a charitable tax credit for the policy’s FMV, which is often far greater than the cash surrender value. But who pays the premium once the policy is donated? If the insured continues to pay premiums, the insured will receive additional tax credits for the premiums paid. If not, the premiums can be deducted from the policy’s cash value, or other donors to the charity can pay the premiums. When the insured dies, the charity will receive a death benefit from the insurer that is usually significantly larger than the initial value of the policy and the premiums.
Let’s take a look at John, a 71-year-old non-smoker who recently suffered a heart attack. John purchased a $500,000 Term 10 policy in 2008. Both the cash surrender value (CSV) and the adjusted cost basis (ACB) is zero. After consulting with an underwriter and actuary, John is deemed uninsurable with a rating of 500% (i.e., his premiums would be 500% higher than normal). Taking these and other factors into account, the actuary establishes that the FMV of John’s policy is $225,000—a substantial increase compared to a CSV of zero.
John has a dilemma. To maintain coverage, he must convert the policy to permanent before age 75; otherwise, the term will expire, leaving the policy worthless. Converting to permanent insurance will result in annual premiums of about $21,000 per year, and John is unsure if he can commit to this for life.
There is a third option: gifting the policy to a charity.
If John were to gift his policy, he would receive a tax credit of $225,000 for the FMV of the donation; this credit can then be applied to reduce his net taxable income this year, or carried forward up to five years. Depending on your province of residence, the maximum total tax savings ranges from between $99,311 to $128,206 at 2016 top marginal rates. To ensure the coverage is secured for the future benefit of the charity, John converts his policy to Universal Life prior to making the donation. If John wishes to continue giving to the charity, he can make additional premium payments that would continue to provide donation tax credits. If not, the charity would have to retain the support of another donor prior to gifting the policy.
What is the process?
Working with an experienced actuary and underwriter is key. An underwriter assesses the mortality risk and life expectancy of the insured person. In conjunction with an actuary, the key features of the life insurance policy are examined to determine the FMV, such as death benefit, cost of insurance, mortality risk, replacement cost, cash value, policy loans, conversion options, riders and other privileges.
Once a valuation has been acquired, the next step is to obtain the support of the charity. They must be first willing to take on the gift, and if the donor does not wish to continue paying the premiums going forward, they will need to find someone else who will. This can take time. And, not all policies are of interest to charities. Cases that make the most sense are typically ones where the clients are approaching 70 or are older, or have had a serious health issue. It just so happens that those tend to be the policies with the biggest fair market values.
Not all life insurance policies are held personally. A policy that is corporately owned may also be a good fit for donation. This can be particularly true for contracts trapped inside a company; situations like this may arise when a company is sold, reorganized or wound up, and taxation makes it costly to transfer a corporately owned policy to a shareholder or another entity. Surrendering the policy is commonly thought of as the only viable option when tax liabilities make other planning strategies prohibitive, but a policy donation can provide a viable way out with an attractive tax credit.
by Jason Pereira, MBA, CFA, CFP, FCSI, CIWM, PFP, FMA, partner and senior financial consultant at Woodgate Financial & IPC Securities Corp, and Brian Cabral, CFP, senior consultant at Gordon B. Lang & Associates.